In a 1D sensitivity example, which two factors are typically correlated?

The correlation between IRR (Internal Rate of Return) and exit cap rate is significant in real estate finance. The exit cap rate is used to estimate the value of a property at the time of sale, which directly influences the projected cash flows and overall returns from an investment.

As the exit cap rate changes, especially in response to market conditions, it affects the eventual selling price of the property. A higher exit cap rate generally indicates a lower valuation for the asset, which in turn could depress the IRR if the cash flows from operations remain stable. Conversely, if the exit cap rate decreases, this may increase the property's valuation and thereby enhance the IRR. This relationship makes them inherently correlated; fluctuations in one will typically reflect changes in the other.

Understanding this correlation is crucial for investors, as it underscores how sensitive an investment's returns are to market conditions and buyer perceptions at the point of exit. Being aware of this relationship helps investors make informed decisions regarding their hold strategies and when to divest, ensuring they optimize returns based on market dynamics.